The Price Mechanism

The Price Mechanism

In a free market economy, resources are allocated through the price mechanism. The price mechanism achieves this through the following three functions:

Rationing

The fundamental economic problem is one of scarcity; infinite wants, but finite resources. The price mechanism resolves this by rationing according to ability and willingness to pay. Where demand is higher than supply, price will rise, eliminating some consumers from the market altogether, while other consumers will buy less.

If there is excess supply, then price will fall, resulting in demand extending and eliminating the surplus.

Signalling

The price mechanism also acts as a signalling mechanism to both consumers and producers; both groups react to price changes by adjusting their consumption and production.

Incentivising

Consumers and producers want to maximise their economic wellbeing. This means that lower prices will encourage consumers to buy more, as they will increase their total utility by switching some spending to buy goods whose price has fallen. Producers, who seek to maximise profit, will be willing to supply more when price rises.

The price mechanism operates in both the short and long run. For instance, there might be a temporary increase in coffee prices, causing a fall in consumption, if there is a crop failure due to a late frost in Brazil, one of the major producer countries. But in the longer term, improvements in technology could increase the size of the harvests, resulting in falling prices.

Exercise

Look at this video on the market mechanism:

Now use your knowledge and understanding of the price mechanism to construct appropriate demand and supply diagrams to show how the markets for diesel powered cars and electric cars will be affected by a big and sustained increase in world oil prices. You should construct two diagrams; one for the diesel car market and one for the electric car market. Consider whether the demand or supply curve will shift in each case and what the effect will be on price and market quantity.